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February 14, 2013

Financial Planning and Commoditization, Pt.1: Defining Terms

As we enter the digital age, technology has been a driving force in putting pressure on many industries, taking any goods or services that could possibly be commoditized and driving their profit margins down to a sliver. In recent years, many have wondered whether financial planning may soon be impacted in a similar manner, especially given how software like TurboTax devastated the profitability of tax preparation services. After all, the commoditization has arguably already begun for some parts of the financial services industry, as costs have plummeted for trade execution and index investing and many software packages offer the ability to perform relatively sophisticated financial planning projections entirely for free.

Yet the reality is that financial planning itself may remain remarkably resistant to commoditization for the foreseeable future, for the simple reason that financial planning is incredibly customized and unique to the needs and complex circumstances of the client, and outcomes can still vary greatly depending on the expertise and the skillset of the planner (unlike tax preparation, where ultimately the outcomes are exactly the same because all clients and their preparers both have to follow the same IRS guidelines).

In fact, arguably the greatest challenge in financial planning is not that services are so nearly identical from one planning firm to the next that the only competitive factor is price (as occurs in commoditized markets), but instead that the planning experience is still so different among firms that consumers struggle to determine which planner would be the best fit in the first place.

Nonetheless, the caveat is that for advisors who have linked the profitability and success of their businesses to a commoditized service, such as charging a fee to gather data and do financial planning software projections, or charge an assets-under-management fee just to provide strategic passive asset allocation using index funds, the “robo-advisors” are a threat and the pressure is on to step up and deliver greater value.

Ironically, in the end that means not only is financial planning not being commoditized in a manner that makes financial planners irrelevant, but the reality may be that it's about to get even more competitive with more financial planners than ever, as an increasing number of advisors realize the components of what they provide have become commoditized and that they must step up to provide a deeper, higher quality of financial planning advice and services for their businesses to survive and thrive.

What Does It Mean to Be Commoditized?

Although it's a term that's often thrown around lightly, the true process of "commoditization" occurs when a particular series of goods become indistinguishable and undifferentiated from one another, such that they are viewed as being perfectly interchangeable with one another. By contrast, goods that have not been commoditized may have several points of distinction, from particular features and benefits to even more ephemeral qualities like brand. This is important because differentiation not only allows businesses to compete based on these qualities, rather than price alone, but also because it allows for a richer and more varied marketplace where there can be multiple companies that survive and thrive, each with their own particular version of the product and each with their own target audience of consumers who buy it.

By contrast, when goods are viewed as entirely undifferentiated and interchangeable, the only way to survive is to compete on price by trying to be less expensive than the competition... if possible. In practice, this can quickly topple businesses, as not every company can drive down its costs of production to provide the good on a cheaper and cheaper basis to undercut the competition. Only the cheapest producer survives in a fully commoditized marketplace. As a result, most goods and services are not completely commoditized, in large part because the businesses that provide them try hard to avoid this outcome, maintaining differentiation by any means possible.

Nonetheless, a great deal of commoditization does exist in many industries. For instance, many types of technology goods have been commoditized; while computer processors may remain competitive because of various processing speeds, more "mundane" parts like keyboards or power supplies or hard drives are often viewed as undifferentiated and interchangeable, where it's easiest to just purchase the cheapest solution.

This is similarly true for many other products as well, from auto parts to construction materials to cleaning supplies. And of course, the term is commonly used for a number of financial markets goods that are similarly viewed as interchangeable "commodities" such as gold, silver, orange juice, cocoa beans, heating oil, and more. Notably, the concept of commoditization can apply in the service industries as well; for instance, internet and cable service has been largely commoditized (although the companies try to differentiate themselves with offerings like premium channels), and commoditization has also struck much of the airline industry, and even annual services like tax preparation.

What Is Being Commoditized in Financial Services?

In the broad financial services industry, many parts of the business have become largely commoditized in recent years, as evidenced by the strong downward pressure on prices for certain services. On the plus side, this allows consumers to get many services cheaper than ever; the downside, however, is that it's a very dangerous environment for companies that risk being made irrelevant if they cannot find a way to cut their own prices enough to compete.

For instance, the execution of investment trades has become almost entirely commoditized over the past two decades, driven heavily by the automation of technology and the rise of online brokers like Charles Schwab and E-Trade; as a result, executing a stock trade a few decades ago might have required the services of a bona fide stockbroker and cost $100-$200 or more, while in today's marketplace if can be done using digital tools for no more than 5% - 10% of that cost from a few decades ago... and in some cases, less, or even entirely free.

Similarly, the world of indexing has also been largely commoditized in recent years, a trend that began with Vanguard but has accelerated with the rise of Exchange-Traded Funds (ETFs). As a result, the investment expenses that must be undertaken to gain raw exposure to the markets just continue to fall lower and lower, as consumers simply buy whatever commoditized indexing vehicle is available at the lowest cost - since, by definition, the actual investments in the index would/should be identical.

Of course, the forces of commoditization have been playing out in other industries related to financial services as well. For instance, the rise of companies like TurboTax and H&R Block have drastically cut the pricing for tax return preparation (which posed a significant challenge to many established accounting firms); arguably, though, tax preparation was especially prone to commoditization risk, since the process is dictated by adhered to IRS rules and therefore everyone should ultimately end out with the same tax return results. Similarly, the rise of online services like LegalZoom has begun to put pressure on the cost for basic legal documents of all sorts, which again are typically identical or substantially similar for at least the majority of consumers (until the needs and situation become more complex for a select few).

In the second part of this post, we’ll finally answer the question—is financial planning becoming commoditized?

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